Fed misread housing bust in '06

Transcripts show how Fed misread housing bust in '06

Friday, January 13, 2012

By Binyamin Appelbaum, The New York Times

WASHINGTON -- As the housing bubble entered its waning hours in 2006, top Federal Reserve officials marveled at the desperate antics of homebuilders seeking to lure buyers.
The officials laughed about the cars that builders were offering as signing bonuses, and about efforts to make empty homes look occupied. They joked about one builder who said that inventory was "rising through the roof."
But the officials, meeting every six weeks to discuss the nation's economic health, gave little credence to the possibility that the faltering housing market would weigh on the broader economy, according to transcripts the Fed released Thursday. Instead, they continued to tell each other throughout 2006 that the greatest danger was inflation -- the possibility that the economy would grow too fast.
"We think the fundamentals of the expansion going forward still look good," Timothy Geithner, then Federal Reserve Bank of New York president, told his open market committee colleagues when they gathered in Washington in December 2006.
Some officials, including Fed governor Susan Bies, suggested that a housing downturn actually could boost the economy, by redirecting money to other kinds of investments.
And there was general acclaim for Alan Greenspan, who stepped down as chairman at the year's start, for presiding over one of the longest economic expansions in U.S. history. Mr. Geithner suggested that Mr. Greenspan's greatness still was not fully appreciated, an opinion now held by a much smaller number of people.
But by the end of 2006, although the central bank officials were oblivious, the economy already was shrinking by at least one important measure, total income. And by the end of the following year, the Fed had launched its desperate struggle to prevent the collapse of the financial system and the onset of the nation's first full-fledged depression in almost a century.
The transcripts of the 2006 meetings, released after a standard five-year delay, clearly show some of the nation's pre-eminent economic minds did not fully understand the basic mechanics of the economy that they were charged with supervising. The problem was not a lack of information; it was a lack of comprehension, born in part of their deep confidence in economic forecasting models that turned out to be broken.
"It's embarrassing for the Fed," said University of Pennsylvania economics professor Justin Wolfers. "You see an awareness that the housing market is starting to crumble, and you see a lack of awareness of the connection between the housing market and financial markets."
Many officials who appear in the transcripts have since spoken publicly about the Fed's failings in the years before the crisis. But the transcripts provide a raw and detailed account of those errors as they were made.
Evidence of problems in the housing market accumulated at each meeting of the Federal Open Market Committee, which sets policy for the central bank. The committee consists of the Federal Reserve governors and presidents of its 12 regional banks.
For a famously private institution known for its cryptic, formulaic statements, the meeting transcripts offer a rare glimpse of senior officials in relatively unguarded conversation, akin to tapes some presidents have made in the Oval Office.
The results are unlikely to burnish any reputations, inasmuch as they could not see the widening cracks beneath their feet. But Fed Chairman Ben Bernanke appears as the most consistent voice of warning that housing market problems could have broader consequences.
At his first meeting as chairman, in March, he said, "Again, I think we are unlikely to see growth being derailed by the housing market." But as the year rolled along, he grew increasingly concerned.
The general consensus on the board, summarized by Mr. Geithner, was that problems in the housing market had few broader ramifications. "We just don't see troubling signs yet of collateral damage, and we are not expecting much," he said in September.
As for Mr. Geithner, who became Treasury secretary in 2009, spokesman Anthony Coley said, "Secretary Geithner was an early source of initiative at the Fed to reduce risk and make the financial system more resilient, even before 2006."
But other Fed officials argued that a housing slowdown would be good for the broader economy.
One fundamental reason for this blindness was that Fed officials did not understand how deeply intertwined the housing sector and financial markets had become. They also were convinced that financial innovations, by distributing the risk of losses more broadly, had increased the strength and resilience of the system as a whole.

Read more: http://www.post-gazette.com/pg/12013/1203211-84-0.stm?cmpid=news.xml#ixzz1jL4tQi15